Gold Rising-Rate Fallacy

Gold has slid during this past week on mounting fears of interest-rate hikes.
Between the latest FOMC meeting's minutes and the Fed's annual Jackson Hole
Economic Policy Symposium, American futures speculators' rising-rate phobias
have been whipped into a fever pitch. They worry gold will be crushed when
the Fed eventually starts normalizing rates. But history shatters this fallacy
that rising rates are gold's nemesis.

Today there is a near-universal belief among futures traders that rising interest
rates are very bearish for gold. The underlying logic is simple. When interest
rates rise, so do yields on bonds and cash in the form of money-market funds.
This makes bonds and cash relatively more attractive to investors than gold,
which yields nothing. Therefore they jettison their gold holdings to migrate
capital back into bonds and cash.

While this thesis may seem sound on the surface, it should be tested rather
than being blindly accepted as truth. The financial markets are littered with
popular notions that later prove dead wrong. And even the sophisticated gold-futures
speculators are not immune. Late last year they scared themselves into a full-blown
hysteria over the nearing start of the Fed winding down its massive QE3
bond-monetization campaign.

So they dumped
gold futures in droves leading up to that dreaded event, as the mere
threat of it in June 2013 battered gold to its worst quarter in 93
years. Yet the very next day after the Fed started its QE3 taper in December,
gold bottomed and hasn't looked back since. Within less than 3 months, gold
had surged 16.2% on heavy buying despite ongoing tapering. Conventional "wisdom" in
the markets is often mistaken.

The winding down of QE3 was a one-time event, totally unique in history since
the Fed had never done such a gargantuan open-ended bond monetization before.
That made it impossible to test, leaving the contrarians out on a limb betting
that QE3 tapering wouldn't prove to be gold's apocalypse. But rising rates
are far different, having happened many times in history. We just have to see
how gold performed in them.

So this week I built a big spreadsheet including nearly 45 years of
daily gold-price and interest-rate data. For rates I used the benchmark yields
on both 1-year Treasury bills and 10-year Treasury notes, in order to represent
both the short and long ends of the yield curve. The result was fascinating,
shattering the popular notion today that rising rates are gold's nemesis. That
is a total fallacy proven false by history.

The past half-century or so has seen two mighty secular gold bulls interrupted
by a great secular gold bear. Gold soared in the 1970s and again in the 2000s,
but drifted sideways to lower for the intervening decades in between. And during the
third of a century since the early 1980s, interest rates have been falling
on balance as represented by these benchmark US Treasury yields. This is an
exceedingly-old trend.

Right away in this high-level strategic overview, the notion that rising rates
are bearish for gold and the necessary opposing corollary that falling rates
are bullish for gold starts to crumble. During the mighty 1970s secular gold
bull, which dwarfs today's so far, gold surged while interest rates were
rising. And then in the 1990s gold slumped while interest rates were falling.
There are plenty of other similar episodes.

So American futures speculators' staunch conviction today that gold and rates
have a strong negative correlation simply isn't true. The proof is not
just visual, but statistical. Over this entire massive span, gold's correlation
with 1-year and 10-year Treasury yields merely ran -0.525 and -0.509. Multiply
these by themselves to get each of their r-squares, and they weigh in at merely
27.5% and 25.9% respectively.

This means that only 28% and 26% of gold's daily price action over the last
45 years was mathematically explainable by changing interest rates! That's only
a quarter, stunningly low in light of today's universal belief that gold's
fortunes are slaved to rates. Thus nearly three-quarters of gold's price
action over our lifetimes had nothing to do with changing interest rates! They
are a minor secondary gold driver at best.

Yes, gold's current secular bull unfolded in a falling-rate environment. But
so did gold's multi-decade secular bear before that. Interest rates' impact
on gold prices is far more indirect and nuanced than the simplistic up-is-bearish
interpretation popular today. Gold prices are dominated by global investment
demand. That, not interest rates, is what investors and speculators must
focus on to multiply their wealth in gold.

When the world's investors want gold, they move capital into it which drives
up its price. Depending on the magnitude of those capital inflows, this can
lead to anything from a single-day rally to a decade-long secular bull. And
when gold falls out of favor with investors, their selling forces its prices
lower. The interest rates only materially affect gold prices indirectly through
their impact on global investment demand.

And since rates have been falling on balance for a third of a century, the
last time we saw a secular rising-rate environment was the 1970s. If
American futures speculators are right today, gold should have been obliterated
then. With yields on bonds and cash high and rising, why would anyone bother
holding zero-yielding gold? But instead of crumbling, gold enjoyed its strongest
secular bull in modern history!

Interest rates rose consistently throughout the 1970s, as the benchmark yields
of 1-year and 10-year Treasuries reveal. And rather amazingly, gold actually
had a strong positive correlation with both yields over that entire
secular rising-rate span! Its 1-year and 10-year daily price correlation came
in way up at +0.797 and +0.910, for r-squares of 63.6% and 82.8%. That is really
high and totally contrary to expectations.

Gold was strong in 1973 and 1974 as rates rose, weak in 1975 and 1976 as rates
fell, and actually soared in 1979 as rates surged! Is this what's in store
for gold during the coming first secular rising-rate environment since the
1970s? Markets are forever cyclical, and after rates fell on balance
for a third of a century they are certainly overdue to rise on balance for
at least a decade if not longer. Higher rates are inevitable.

So why did something so radically counterintuitive based on conventional wisdom
happen during gold's last secular bull? If investors and speculators can wrap
their brains around this, they will realize that rising rates pose little threat
to gold today. Provocatively, just the opposite is true. Rising rates may very
well prove to be an exceedingly-bullish force rekindling vast amounts
of global gold investment demand.

This heretical assertion hinges on gold being one of the leading alternative
investments. These are defined as assets that are not the traditional
dominant three of stocks, bonds, and cash. When stocks and bonds are thriving,
investors have no need to look for alternatives. But when stocks and bonds
roll over into bear markets, alternatives really start to shine. And gold
has long been the king of that realm.

Rising interest rates are actually extremely bearish for stocks and bonds! As
rates rise, yields on bonds including "risk-free" Treasuries climb. This makes
bonds relatively more attractive compared to stocks, especially for those seeking
income. And because Wall Street usually includes interest rates when measuring
stock-market valuations, higher rates make stocks look more overvalued which
leads to selling.

So as rising rates weigh on stocks, reducing investor demand for them, alternative
investments look a lot more attractive and return to favor. If the stock selling
feeds on itself enough, cyclical bear markets can form. They tend to cut
stock prices in half over a couple years or so. And that's exactly what
happened in 1973 and 1974. During those two years, the flagship US S&P
500 stock index (SPX) fell
by 41.9%.

So investors looked for alternatives, and flooded into gold. Their buying
blasted it up 186.4% in 1973 and 1974 while short rates were surging and long
rates were rising! Even though 1-year and 10-year Treasury yields averaged
jaw-dropping by today's standards levels of 7.8% and 7.2% over those couple
years in the mid-1970s, investors still didn't hide out in cash or pour vast
sums into bonds. They wanted gold.

Cash wasn't popular despite high yields because it was far-underperforming
gold. Why earn 8% or less in a money-market fund when gold was blasting
up 60%+ annually? Even if that number was just 15% a year, it still trounces
cash. The same thing will likely happen in the next rising-rate environment.
Will a 3% money-market yield, which seems unattainably high today, prove
more attractive than gold itself?

Very unlikely. Since its secular bull was born in April 2001, gold has enjoyed
a compound annual rate of return of +12.8% as of this week despite being relatively
low and out of favor today. Compare this to the S&P 500's mere +4.2% over
that same secular span even at today's euphoric records. When the stock markets
roll over again, gold should have no problem easily achieving annual gains
of at least 15%.

And just like in the 1970s, rising rates are likely to be a major driver of
stocks' next cyclical bear. Ironically the same is true with bonds. Higher
yields do attract new bond investors, but only if those yields are stable.
Why? Bond prices move inversely to yields. As rates rise, the prices
of all existing bonds drop as sellers force them to lower levels to make their
existing fixed coupons equal current market yields.

The bond markets have enjoyed one of the biggest and longest secular bulls
ever witnessed over the past third of a century because rates fell on balance.
But when rates start rising on balance, bond prices are going to fall for
as long as rates rise. That means all investors who can't hold every bond to
maturity, including bond funds, are going to watch the principal value of their
bond portfolios relentlessly drop.

They won't want anything to do with bonds if their yields don't handily exceed
this erosion of their capital invested. Imagine the Fed hikes rates far enough
to see long Treasuries yielding 7%. That is almost inconceivable after years
of the Fed's zero-interest-rate policy. If Treasuries yield 7% but bond investors
are losing 5% a year in principal, their net gain is just 2%. That won't even
keep pace with inflation, of course.

So if bonds are falling and stocks are falling, why not buy gold which will
be gaining double digits again year after year? Alternative investments thrive,
investment demand for them soars, when traditional stock and bond markets are
weak. And nothing pushes stock and bond prices lower more effectively and relentlessly
than rising-rate environments. Rising rates are likely to drive capital
into gold like nothing else can.

Gold was weak in 1975 and 1976 as rates fell, losing 27.8%. Why? Because the
SPX shot 56.7% higher in a new cyclical-bull bounce out of the preceding cyclical
bear. But soon after the stock markets stalled again in 1976, gold caught another
bid. It continued powering higher in 1977 and 1978 despite rates rising relentlessly,
especially on the short end of the yield curve. And both rates and gold soared in
1979.

When rates rise fast, not only does their potential downside impact on stock
and especially bond prices accelerate, widespread inflation fears are
kindled. And neither stocks nor bonds do well in periods of high inflation,
but of course gold thrives. So if the markets wrest control of the upcoming
rate rise away from the Fed, sharply higher rates are far more likely to push
more capital into gold than pull money out of it.

Many traders today believe high rates killed the secular gold bull of the
1970s, but the truth is once again more complex. In less than 6 months between
August 1979 and January 1980, gold skyrocketed 200.4% higher! Seeing any already-high
price triple in such a short span of time is the hallmark of an unsustainable
popular mania. After such a parabolic climax, gold's bull was due to fail regardless
of rates.

Bond demand didn't surge again until rates stabilized, until investors finally
believed that their principal invested would be relatively safe. And even if
those ultra-high rates prematurely killed gold's bull, way up above 16% on
the short end and nearing 14% on the long end are radically above anything
we are going to see in the coming years. Gold thrived in the 1970s up until
13% in both 1-year and 10-year terms.

Today's secular gold bull that was stealthily born in 2001 happened in a far-different
environment, highlighting that rates are only a secondary gold driver. Over
the past 13 years or so, long rates have fallen on balance while short rates
have only materially risen one time. And contrary to futures speculators' outlooks,
gold rallied while short rates surged and rallied with long rates far higher
than today's.

Since early 2001 the correlation r-squares of gold with 1-year and 10-year
yields have been 43.8% and a high 76.3%. Both are based off of negative correlation
coefficients. But with rates falling on balance while gold rose on balance
over this span, a negative correlation was inevitable. Focusing on that high-level
relationship exclusively masks the true performance of gold in high and rising-rate
environments.

Between April 2001 and August 2011, gold's latest secular-bull high, this
metal powered 640% higher. This compares to a horrendous 2% loss for the SPX
over that same span, by the way. But during those prime secular-gold-bull years,
1-year Treasury yields averaged 2.24% while 10-year Treasury yields averaged
4.09%. This is 22.4x and 1.7x higher than today's levels respectively, or many
rate hikes higher!

So if gold thrived so incredibly while rates were far higher, why on
earth are rising rates perceived as a threat to gold at all as long as they
remain below 5% or so? That was the upper range of 10-year yields during gold's
secular bull, and even of 1-year yields. And between mid-2004 to mid-2006,
the Fed was on an aggressive tightening cycle. It catapulted the federal-funds
rate that it directly controls from 1.00% to 5.25%!

This was a monstrous increase in a short period of time, far more extreme
than what the uber-dovish Yellen Fed is expected to do in the next tightening
cycle. If American futures speculators are right that rising rates are a mortal
threat to gold, it should have been wrecked during that last sharp tightening.
Yet this metal actually surged 56.4% higher over that 2-year span where short
rates effectively quintupled!

If gold's secular bull was strong in far-higher rates than today's, and gold
powered higher during the last steep rate-hike cycle, it seems pretty silly
for investors and speculators to fear the next round of rate hikes today. Gold
and everything it drives including the flagship GLD gold ETF, silver, and the
stocks of the precious-metals miners are likely to thrive during the next rate-hike
cycle as general stocks and bonds get hammered.

And for several reasons, the Fed's next rate-hike cycle is likely to be exceedingly
gradual. The Yellen Fed has telegraphed this, and stock traders universally
expect it. If the Fed hikes rates too fast, it will risk spawning a panic-like
selloff in the topping and dangerously
overvalued US stock markets. And fast rate hikes risk igniting cascading
bond selling too, which would rapidly catapult rates up out of the Fed's control.

The Fed will also do everything in its power to slow the rise in rates because
of the extreme US federal-debt levels. Merely normalizing short and
long rates to long-term averages would literally bankrupt
the United States government! Soon interest expenses to service Washington's
enormous debt would expand to eat up all discretionary government spending.
There is no way the Fed will risk destroying the US government.

Contrary to popular belief, rising rates are no threat to gold. This metal
soared in the 1970s during the last secular rising-rate environment as stocks
and bonds got hit. Gold powered higher again in the 2000s with both short and
long rates far higher than today's levels. And gold surged during the only
major modern rate-hike cycle seen a decade ago, when the Fed more than quintupled
short rates.

Prudent investors and speculators study history to test popular opinion, as
emotions often cloud the collective judgment of traders. What would you rather
rely upon to grow your capital, someone's mere belief or the evidence from
history? American futures speculators are dead wrong today that the Fed's coming
rate-hike cycle is a mortal threat to gold. The weight of evidence strongly
supports the bullish contrary view.

Sadly contrarians are hard to come by, very few people are willing to fight
the herd and suffer ridicule to buy low and sell high. Yet that's where fortunes
are made, buying things like today's precious metals that are cheap and loathed
and then later selling them when popularity returns. That's what we do at Zeal.
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The bottom line is the popular notion that rising rates crush gold is totally
false. Gold rocketed higher in the 1970s when both short and long rates were
already very high and rising. And gold soared in the 2000s when rates were
far higher than today's. It even surged during the Fed's last major rate-hike
cycle a decade ago, which was quite sharp. Rising interest rates are not gold's
nemesis, and not even a real threat.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
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